The growth of cloud IaaS in China is why we are invested in Kingsoft Cloud. Below, we review this company in light of a missed earnings report and weaker price action than some of our other positions.
Background on KC:
Kingsoft Cloud specializes in internet streaming, yet has incredibly strong parent companies for an opportunity this size. The two parent companies are Xiaomi, the number three mobile device globally second to Apple and Samsung, and Kingsoft Corporation, which is a software company from the 1990s that is the equivalent of Microsoft Office in China.
Xiaomi gives its traffic to Kingsoft Cloud, and therefore, mobile streaming and internet traffic is a specialty. This is seen in the client list of ByteDance (Tiktok), iQIYI, Bilibili and NetEase. Notably, Xiaomi is on the blacklist but this isn’t too surprising as a mobile company.
What is interesting to me is the internet-of-thing (IoT) footprint that Xiaomi has, which is the largest in China. According to Harvard Business Review, Xiaomi has surpassed $37 billion in IoT revenue from more than 210 IoT devices excluding smartphones and laptops. The article is a good read as HBR did a “multi-year” review on how Xiaomi grew its market by targeting price conscious and tech savvy consumers. The company then strategically set up retail locations to attract IoT purchases.
Kingsoft Cloud is also moving quickly into the enterprise cloud, which should help the company diversify from public cloud (i.e. the mobile/internet streaming). You’ll see below in the Financials section that this is where the majority of the growth is coming from. The company noted verticals such as Finance and Health Care as their major focus. This entry shouldn’t be terribly difficult given the parent company Kingsoft Corporation holds a spot similar to Microsoft Office in China with enterprise customers using the WPS Office software.
The reason Kingsoft Cloud can be considered a bit safer than other Chinese stocks, in my opinion, is that the company is on a $1 billion annual run rate. In addition, China has made it clear that becoming a leader in 5G and AI is a primary focus and this is impossible without a larger cloud IaaS footprint. There is a serious gap here in the country’s ambitions compared to the country’s capabilities. We first covered this with our Alibaba premium research report where we said the following:
“China’s enterprise IT market is five to seven years behind the United States and Western European markets. Once fully mature, China’s need for cloud infrastructure will rival the United States with 3x the population and a bottomless appetite for smart cities, artificial intelligence and machine learning plus manufacturing IoT automation.
The reversal of where China is today with cloud IaaS, and where China will be in five years, could be a bigger story than the B2B marketplace as the growth is closely tied to China’s position as a global leader.
In 2017, China published a roadmap on how it seeks to become a global powerhouse in AI. According to the report entitled “Next Generation Artificial Intelligence Development Plan,” the domestic AI market will be worth a total of $150 billion. Today, China’s AI market is worth $6.2 billion.
Artificial intelligence and machine learning require private cloud and public cloud infrastructure-as-a-service (or a hybrid mix with on-premise servers) as storing data in separate silos weakens AI and ML capabilities, reduces training performance and lowers accuracy. Artificial intelligence and machine learning require speed with most AI solutions split between 40/60 with private/public cloud or 60/40 if you’re a regulated industry.”
Although we closed our position in Alibaba, a similar thesis applies to Kingsoft Cloud.
Overview of Cloud IaaS
In the Top 10 LTBH webinar when I covered Datadog, I had stated that if the tech giants all believe cloud IaaS is the most critical layer into the foreseeable future, who am I to argue with this?
The chess game has been set with AWS’s Andy Jassy now CEO of Amazon and Azure’s Satya Nadella as CEO of Microsoft. I’ve also made the case that Google better hurry up and find its focus because these two heavyweights have chosen their primary focus and direction for the next decade.
Basically, I want exposure to this strong positioning. Although SaaS shows the most revenue overall globally, it’s being clearly communicated from Big Tech that IaaS is the most important layer. I could write a whole report on why that is (and will when I cover Datadog soon). Primarily it’s not only the infrastructure for software but is also the infrastructure for AI, ML and 5G.
Regarding Kingsoft Cloud, it’s centered in this trend and in the region where the most growth will occur. In fact, China is unique from the United States because cloud IaaS is China’s largest category in terms of revenue whereas software is the largest globally.
Here are estimates from Statista:
Source: Statista
The interesting part is that China grew much, much faster than these estimates predicted. In fact, due to Covid, Alibaba reported 60.1 billion Yuan in fiscal year 2021, or about $10 billion USD.
According to IDC, the Q4 cloud IaaS market in China was at $3.49 billion, or annual run rate of $14 billion. If we look at the size of the global IaaS market, which Gartner states was $82 billion in 2021, then we see China is equal to about 17% of the market if we calculate with the 2021 average of $14 billion.
The market in China is expected to grow at 28.3% CAGR compared to United States growth of 20.3% CAGR from 2019 to 2024. Notably, these estimates were given prior to Covid.
If we take only the public cloud market, Frost & Sullivan predicts the market will grow from 81 billion RMB to 368 billion RMB in 2024 – or nearly 5X. Right now, China has about 6.5% of the global public cloud market and this is forecast to grow to 10.5% by 2024.
As outlined in the S-1 filing, the same firm predicts that China’s internet cloud market will grow 4X from roughly $50 billion RMB to $215 billion RMB and the enterprise market will grow 3X from $108 billion RMB to $345 billion RMB.
Of the 17% that China has, Kingsoft Cloud stated in the S-1 filing from 2019 that they have 5.4% in terms of revenue from IaaS and PaaS.
The estimates indicate that China will take increasing market share in cloud IaaS as the country catches up to other developed regions. With many segments expected to double in percentages, we can comfortably assume China will own 20% of the cloud IaaS market.
If Kingsoft Cloud grows to own 10% of the market, and we figure $23 billion for the Chinese market in two years ($14 billion at 28% CAGR), then the company should hit around $2.3 billion in annual revenue.
$2.3 billion happens to be what the analyst estimates are, as well, for FY 2022
This implies growth of about 50% this year from annual revenue of $947 million to $1.5 billion and also 49% growth the following year.
Financials
This quarter, Kingsoft Cloud reported growth of 30% for $1.81 billion RMB in total revenues, equal to $277 million USD. This means Kingsoft is a $1 billion USD annual run rate, which is rare for China. Public cloud makes 77% of revenue with enterprise cloud 23% of revenue. The enterprise cloud grew 131.3% in the most recent quarter.
The revenue missed consensus of $1.88 billion RMB.
Despite tougher comps following Covid, Kingsoft is guiding for second quarter revenue growth of 39% to 45%, which represents a reacceleration from Q1. However, the company’s guidance of 2.13 billion RMB to 2.23 billion RMB is also under Q2 analyst consensus for 2.41 billion RMB.
Last year, the company reported 58% growth in Q2 2020. As with all Covid beneficiaries, analysts are timid as to KC’s growth in the back-half of the year as the company reported 75% and 72% in revenue, respectively. This means the hurdle is higher for KC in Q3 and Q4. Perhaps the stronger guide for Q2 is a good sign. The company repeated many times that the backlog is healthy with RMB 2.8 billion, or $432 million (a little over a quarter’s worth of revenue). This does not include new bids from Q1, which management alluded to included “some big internet companies.”
The adjusted gross margin increased from 4.9% last quarter to 6.7% this quarter. In the earnings call, management noted the improvement was attributed to the financial and health care verticals, and the contribution of public cloud’s revenue and margin.
The company has a cash position of RMB 5.46 billion, or about $840 million USD. The company’s loss per share improved from RMB 0.39 to RMB 0.11 or ($0.02) per share.
Valuation:
It takes about two seconds to see the massive discount Chinese that stocks are trading at compared to stocks in the United States. Kingsoft is not immune to the China discount as it has more revenue than cloud stocks Okta and Datadog yet trades at 1/6 the forward P/S.
When the chart below is adjusted for a 3-5 year time frame, we see it has been since March of 2018 that Chinese stocks and United States stocks traded in the same range of 15 P/S. There was a strong decoupling after early 2018.
Kingsoft held the 15 P/S range in February of 2021 so it’s not out of the question the company could return to this valuation. It would need to meet/exceed guidance on Q2 and to guide strong for Q3-Q4 to resume these levels. Cloud IaaS is fully capable of this because it tends to be a steady performer.
Management:
Jun Lei, the CEO of of Xiaomi, serves as the Chairman of the Board of Directors. He has been with Kingsoft since 1992 and was also previously the chairman of Cheetah Mobile. The CEO of Kingsoft comes from Phoenix New Media, an internet, mobile and television company in China. The Board also has members who previously held roles at Google/IBM and IDG Capital/McKinsey. Management has members with experience from Goldman Sachs Asia (CFO), enterprise cloud company Qiniu, gaming company Zynga and Baidu.
The most critical member is Jun Lei as he accomplished the unusual feat of rising to the top of China’s most treasured industry – mobile. He overcame Apple for the number one spot in China in 2014 and is now in the number three spot. To be frank, he did this by ripping off Apple, but nonetheless it was an accomplishment as United States companies dominated China prior to this breakthrough.
In 2013, he was appointed a delegate of the National People’s Congress.
Risks:
The risk to Kingsoft Cloud is not the addressable market, the growth/demand and timing, or even number of competitors. The risk is the size of its competitors. Cloud SaaS in the United States is a great example of a category where competitors tend to be similar sized, and therefore, the playing field is level. This isn’t the case with cloud IaaS where BAT (Baidu, Alibaba, Tencent) rules China like MAG (Microsoft, AWS and GCP) rules the United States. Now we have to add H to the acronym for China as Huawei is growing rapidly.
Kingsoft Cloud is the largest independent cloud provider, which means there is no conflict of interest for internet companies to work with KC as they don’t directly compete. Tencent and Baidu, for example, compete with smaller internet companies.
Another prominent risk is the costs associated with building out infrastructure. The adjusted gross margins are drastically lower than the SaaS category in the 70%+ range. You can also see the costs associated with IaaS reflected in the IDC costs, which cover bandwidth and racks. These costs range between 68% of revenue in 2020 to 77% of revenue in 2017.
We’ve covered the fact that Kingsoft Cloud is not audited in this write-up here.
Conclusion:
We try to have a diversified portfolio across tech and China is a region we want exposure to. With that said, China is not for everyone. For the I/O Fund, it’s easier to invest in a stock in China long-term that has solid parent companies and is participating in a predictable trend.
We will need to see one of two things happen for Kingsoft Cloud to resume its previous valuation of 15 P/S. The company needs to come in strong in the second half of the year or we need to see China come back in favor. The first one is where we have focused our efforts in this analysis.
We think a cloud IaaS company with $1 billion in revenue and 50% growth is investable. It has a rock bottom valuation coupled with the recent history of trading at a much higher valuation.
Additional Reading:
Alibaba Premium Analysis 2019
August 14th: Alibaba Quick Glance
Alibaba and Ant Group Premium Research Report
Kingsoft Cloud (KC)